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Tuesday, October 06, 2009

Philippines: Sustainable growth and fiscal policy

The Philippine economy recorded a broad based bounce back in Q2 2009 from the weakness in Q1, growing by 2.4% on the quarter – better than we expected. Business confidence and regional data suggest there is more to come in terms of the recovery.

Against these positive trends, the human calamity caused by Tropical Storm ‘Ondoy’ or ‘Ketsana’ could disturb the growth path of the economy. However, while disrupted economic activity along with damage to corporate and household balance sheets are both human and economic negatives, the rebuilding effort – probably led by the public sector – could provide a temporary lift for economic growth in coming quarters.

However, any extra public expense would come on top of an already sharp deterioration in government finances. But we argue that, in the context of a cyclical economic recovery, the Philippines can sustainably run a wider budget deficit – perhaps in the order of 4-5% of GDP without pushing the debt to GDP ratio higher in 2010 and beyond.

The Philippine economy recorded a broad based bounce back in Q2 2009 from the weakness in Q1, real GDP growing by 2.4% on the quarter. This rebound built on a reasonable relative growth outcome over the last year such that the economy expanded by 1.5% on the year in Q2 2009 against sharp contractions in Singapore, Malaysia and Thailand. Business confidence and regional data suggest there is more to come in terms of the recovery.

Recovering growth and the Storm

Against these positive trends, the human calamity caused by Tropical Storm ‘Ondoy’ or ‘Ketsana’ could disturb the growth path of the economy. Ondoy was the worst storm to hit Metro Manila since 1967; on 26 September a month’s rain fell in 12 hours. Almost unprecedented flash floods resulted, inundating more than half of metro Manila at one point. Thankfully the storm passed quickly and flood waters began to recede fairly rapidly, although there are areas of the capital that remain flooded.

The impact of the storm was mainly on the Metro Manila area, with the agricultural areas outside the national capital region seemingly less badly hit. Sadly, Manila’s population density has magnified the human calamity brought by the storm.

For the economy the likely impact of the storm will take the form of (a) near term disruption to economic activity (b) negative balance sheet (wealth) effects arising from the damage to property and (c) a boost to economic activity from the rebuilding effort, mostly likely assisted by the public sector.

In particular, the damage to property and wealth may well reduce confidence and adversely affect household or corporate balance sheets, but the impact on economic growth from rebuilding could mean that there is only a modest impact on GDP growth in 4Q09. And certainly the negative impact on economic growth by 1Q10 should be limited.

Official estimates suggest a 3% loss of the annual rice crop, against government rice stocks equivalent to 8-10% of annual demand, amongst other less significant crop damage. Nonetheless, precautionary buying of basic goods and services could cause a lift to inflation despite government price controls. However, the impact should be seen as temporary by the BSP, which will play down risks to long term inflation expectations and keep monetary policy settings easy for now.

As such, while economic activity may be temporarily impacted by the tragic floods seen on the weekend of 26 September, the rebuilding effort will likely help the trend recovery in activity to continue in coming quarters. We retain our forecast for 4.6% growth in 2010, but edge up our 2009 real GDP forecast to 1.3%

- less than we would have done in the absence of the Storm Ondoy.

Pressure on government finances? It is also probable that the storm’s fallout and the response to it will become a focus of political controversy. To the extent that the government struggled to cope with the extent of the flooding, the storm may prove to be negative for the incumbent political group in next year’s election. This effect will be mitigated if flood waters subside quickly, as they have been so far. However, with more potential tropical storms brewing, there may be more trouble to come.

In response to this political risk, the government may well move to spend more money and widen the National Government deficit further. The deficit is already widely expected to break the 3.2% of GDP or 250bn target for the year; as of August the deficit was already 210bn pesos. How much should investors worry about a still wider fiscal deficit?

At first glance there appears genuine reason to be concerned. Chart 2 shows the national government balance to have reversed the consolidation since 2004. And while the wider deficit is partly due to an increase in spending to GDP, the revenue to GDP ratio has fallen to one of its lowest levels since the Asian crisis.

Three reasons not to get too concerned over the wider fiscal deficit However, things may not be as bad as they look – for three reasons:

(1)

Much of the decline in revenues and hence the widening of the fiscal deficit is likely to be cyclical not structural.

(2)

The Philippines can afford to run a deficit in the order of 4-5% of GDP

(3)

Given excess savings, it makes sense for the government to mobilise those savings for the purpose of investment

We tackle each of these themes in turn.

Cyclical rather than structural drivers Deteriorating public finances are not an outcome specific to the Philippines. Chart 3 shows that the deterioration in the Philippines fiscal balance is not exceptional in an Asian and global emerging market context.

Nonetheless, our conversations with market participants suggest concerns have grown with the latest revenue figures. These seem to have conclusively reversed all the gains in revenue collection that came with the increase in sales tax rates at the beginning of the current administration.

But even here the Philippines is not alone in recording declining revenues, although the decline in revenue to GDP on the last data point seems worse than seen in the rest of Asia. We suspect a common regional driver of weaker tax revenue, resulting from cyclically lower income and trade, accounts for at least half the decline in revenue to GDP.

A wider deficit could be sustainable This said, even if half to three quarters of the decline in revenue to GDP were reversed with a cyclical recovery, the fiscal balance would still be in deficit by around 2-3% of GDP. However, a wider deficit of around 4-5% of GDP could prove to be sustainable (consistent with a stable debt to GDP ratio) in our view.

The reason lies in the relationship between the government’s borrowing, its cost and the growth in the economy. The following formula defines the primary balance (the fiscal balance excluding interest payments) that results in a stable government debt to GDP ratio:

ps = d*(r-g)

where ps is the primary fiscal surplus (fiscal surplus before interest) required to stabilise the debt/GDP ratio, d is the current debt/GDP ratio, r is the real interest rate and g is the real GDP growth rate.

Now, the interplay between the primary deficit, real growth and interest rates is not the only factor working on government debt. The decomposition of Philippines public debt changes since 2001 in Chart 5 shows other factors at work. But assuming stable exchange rates and no other debt impacting flows (eg: nationalisation/privatisation), the relationship between the primary deficit, growth and interest rates will necessarily be key for changes in public debt to GDP.

With this in mind, the table below shows the debt stabilising primary surplus given various GDP growth rates, interest rates and a National Government outstanding debt stock to GDP of 56% – as it stood in June 2009. The difference between real and nominal interest rates is assumed to be in line with the BSP’s inflation target mid-point of 4.5%. The final column shows the associated sustainable (or debt stabilising) overall National Government fiscal balance for each growth rate of real GDP.

Table 1: Primary and overall fiscal balances consistent with stable National Government debt to GDP.

Effective nominal interest rate on NG govt. debt

6.0

6.5

7.0

7.5

8.0

8.5

9.0

Required

Effective real interest rate on NG govt. debt

1.5

2.0

2.5

3.0

3.5

4.0

4.5

overall NG fiscal balance

to stabilise

Real GDP growth

Primary balance required to stabilise the level of government debt to GDP

debt to GDP

2.5

-0.6

-0.3

0.0

0.3

0.6

0.8

1.1

-3.9

3.0

-0.8

-0.6

-0.3

0.0

0.3

0.6

0.8

-4.2

3.5

-1.1

-0.8

-0.6

-0.3

0.0

0.3

0.6

-4.5

4.0

-1.4

-1.1

-0.8

-0.6

-0.3

0.0

0.3

-4.8

4.5

-1.7

-1.4

-1.1

-0.8

-0.6

-0.3

0.0

-5.0

5.0

-2.0

-1.7

-1.4

-1.1

-0.8

-0.6

-0.3

-5.3

5.5

-2.2

-2.0

-1.7

-1.4

-1.1

-0.8

-0.6

-5.6

Source: UBS

The message from the above analysis is that if real economic growth is above the real interest rate, then the government can run a primary fiscal deficit (fiscal deficit before interest payments) without the debt to GDP ratio trending higher – assuming no impact from exchange rates and other debt creating flows.

And importantly given this result, from 2004-2008 the effective real interest rate on Philippines’ government debt has been below the real GDP growth rate by a healthy margin.

This is unlikely to be the case in 2009 however. The slump in real growth and extremely low price growth means real interest rates will be higher than real growth this year. This, along with a primary deficit of close to zero, points to a rise in the debt stock to GDP in the region of 2 percentage points of GDP, to which adverse currency movements will also add. As such we expect an end year National Government debt stock closer to 60% of GDP than last year’s 57% (but still well below the 2004 peak at 95% of GDP).

Next year, however, inflation and real growth should rise. The question for market participants is to what degree this will restore the margin between real growth and real interest rates. Even though the government’s nominal interest burden can change only gradually with the rolling over of the debt stock, a perceived incompatibility between market real interest rates, the growth rate of the economy and the primary deficit could spark off currency weakness and declines in asset markets.

Fortunately, there is reason to believe that real interest rates could return to relatively low levels. In contrast to the years prior to 2004, the pool of funds or savings in the Philippine economy available to be directed towards funding government spending is relatively healthy. This is particularly true relative to the historically low investment share of GDP (Chart 7). Indeed, instead of being deployed domestically, these excess savings are reflected in the balance of payments as a current account surplus or financial account deficit (net capital outflow).

With the current account surplus (partly as a result of remittance flows) sustained at 5.2% of GDP in Q2 2009, the Philippines excess savings pool is intact and consistent with real interest rates being depressed relative to real GDP. This in turn, according to Table 1, should allow the Philippines government to run a modest primary deficit, and an overall fiscal deficit in the order of 4-5% of GDP, without delivering a rising debt to GDP ratio.

It makes sense for the government to mobilise excess savings Finally, a wider deficit could be a positive for the economy. While private investment is usually more productive than public investment, Chart 7 shows that despite higher savings in recent years the investment share of GDP remains at the low end of its historical range. Indeed, without the 30% growth in public construction investment in the year to Q2 2009, the investment share of GDP would have been even lower as equipment investment contracted 17.1% on the year in Q2 2009.

Work by Andy Cates of UBS’s global economics team recently highlighted the role of investment in building the nation’s capital stock and supporting trend GDP growth over time1. As such, assuming public infrastructure is productive – and in the Philippines there is little debate that more is needed – the government could lift trend growth by investing the national economy’s excess savings in infrastructure while running a deficit. The same rationale works for re-building the capital stock lost to natural disasters such as last weekend’s storm.

And as we show above, so long as the National Government’s deficit spending does not drive up real interest rates too much relative to real GDP growth by competing with the private sector for the pool of savings, a modest primary deficit should be consistent with stable debt to GDP. And that in turn would be consistent with an overall deficit of 4-5% of GDP.

Such an approach would risk a higher debt burden in the event of disappointing growth. But given the low level of capital stock in the Philippines and the potentially buoyant incremental returns to higher rates of capital accumulation, that is a risk investors should probably forgive the Philippines for taking2.

Investment implications Because of the excess savings evidenced by the Philippines’ current account surplus, we do not expect a fiscal of 4-5% of GDP to result in sharply interest rates or for it to hinder the economic recovery underway. This said, a gradually steeper yield curve may result as the government faces a little more competition for funds from recovering private sector demand.

We maintain our 2010 Real GDP forecast of 4.6%. However, because of the potential drag on growth from the recent flooding in Manila, we only modestly increase our 2009 real GDP forecast to 1.3% (from 0.8%) following better momentum than expected in the Q2 national accounts data.

Also in the light of the storm, we also modestly revise our CPI inflation forecast to 4.1% in 2010 (previously 3.8%). Our projection for modest policy rate tightening in Q2 2010 remains unchanged. We continue to forecast only 4.5% rates by end 2010.

However, in the light of the continued growth in remittances year to date – and the implications of the Storm for re-building efforts and remittance flows – we revise our remittance growth forecast to 7% in 2009 and 5% in 2010. Meanwhile, we foresee a fiscal deficit of 3.9% of GDP (300bn pesos) in 2009 and 3.6% of GDP (300bn pesos) in 2010. Linked to this, we now forecast a current account surplus of 4.5% and 3.8% of GDP in 2009 and 2010 respectively.

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